Islamic Microfinance: Moving Beyond Financial Inclusion

IRTI Working Paper Series WP# 1435-11 Islamic Microfinance: Moving Beyond Financial Inclusion Abd Elrahman Elzahi Saaid Ali 28 Shaban 1435H June 26, 2014 Islam2c Economics and Finance Research Division

IRTI Working Paper 1435-11 Title: Islamic Microfinance: Moving Beyond Financial Inclusion Author(s): Abd Elrahman Elzahi Saaid Ali Abstract The current situation of high unemployment and the widening whole of the disadvantages people in Muslims countries have spot light the need of proper access to the microfinance Currently poor and low income people in Muslim countries has little access to either conventional or Islamic microfinance. This article is an attempt to investigate to what extend Islamic microfinance can best help in alleviating poverty in Muslim communities. The results showed that the conventional microfinance concentrates on the low-income group and thus financial and socially excluded the destitute people from microcredit and other related activities such as saving and skills improvement. Further more the resluts indictes that Islamic microfinance is moving beyond conventional counterpart to provide effective social and financial inclusion simultaneously through its Islamic social tools such as Sadaqah, waqf and Zakah, that to be given directly to the extremely poor in cash or in kind to satisfy their basic needs before granting them microcredit. These results might give good an implication to those who provide microfiance in these countries to improve the social and fiancial inclusions of the disadavantages people by adopting Islamic microcredit. Key Words: Islamic micro financing, Zakat, Waqf, Social inclusion, financial inclusion JEL Classification: G21; G28; G29; O12, O16, L25 IRTI Working Paper Series has been created to quickly disseminate the findings of the work in progress and share ideas on the issues related to theoretical and practical development of Islamic economics and finance so as to encourage exchange of thoughts. The presentations of papers in this series may not be fully polished. The papers carry the names of the authors and should be accordingly cited. The views expressed in these papers are those of the authors and do not necessarily reflect the views of the Islamic Research and Training Institute or the Islamic Development Bank or those of the members of its Board of Executive Directors or its member countries. Islamic Research and Training Institute P.O. Box 9201, Jeddah 21413, Kingdom of Saudi Arabia

Introduction: Many rural disadvantages in Muslim countries particular in central Asia and sub saharah Africa and MENA region. They have no proper access to the formal lending either conventional or Islamic financing. Moreover, the lending institutions are even not spread enough to reach these needy people. Private and foreign banks that seek to maximize their profits are concentrating only on the urban cities. Poor projects are left only for the public banks because of their high risk that associated with lending to the poor or micro producers. Given the high poverty among these low income groups and the unavailability of collateralization mechanism, lending this group normally associated with greater risk as reflected in the banks high non-performing loans in some countires like Morocco. Because, the majority of the Muslim countires are Muslim by birth, Islamic Microfinance is one way to meet the financial needs of these people to achieve better financial inclusions even for the non- Muslim poorest minority living among them. Islamic microfinance can provides small loans for the poor people or people having good expertise without start-up capital. Unlike conventional, Islamic microfinance generated its vision from Islamic worldview. Its grants finance to the needy for self employment based on maqasid al-sharaiah. Islam always encourages poor self-employment rather than just donating money and food just for consumptions. Giving tools of production to the very poor people is superior to the donation of consumable charity (hadith). The self-employed poor will be empowered to care for himself and his family. The World Bank declared the microfinance as means of eradication inequality and poverty. Islam has more than means of eradication income inequality such as zakat and sadaquah to be given directly to the needy for solving the urgent needs. Hence, Islamic microfinance is targets the very poor people who are capable of doing work for producing goods or services. While zakat and sadagah should be paid only for specified people, Islamic microfinance is not. Islamic microfinance can be used to mitigate the negative impact of the high unemployment among the youth in Muslim countries. Evidence has showed the employment is the highest in the world among the adult and youth at same time in most of the Muslim countries. Islamic microfinance can be used as quick respond targeting to finance small entrepreneurship such as small and micro enterprises (SMEs). Hence, Islamic microfinance can be used effectively to overcome the problem of hyper unemployment and the challenges facing SMEs in accessing suitable finance in Muslim countries. As the case of other Muslims countries, the Sudanese experience, showed Islamic microfinance has

positive impact on the income generating activities. In addition to other poor in the societies, in Sudan Islamic microfinance used to finance graduate students as a part of the unemployed youth sector. Despite of the positive impact of Islamic microfinance in many Muslim countries, the borrowers are still dominated by the traditional sectors. Unfortunately most of these sectors faced more challenges in most Muslims countries. These challenges include but not limited to the basic infrastructures, financial infrastructures and far and unreachable markets. These challenges have negatively impacted the accessibility of Islamic microfinance by raising the cost of finance in many Muslim countries. Other challenges facing Islamic micro-finance in Muslim countries, is high cost and the riskiness of financing poor borrower due to the small size of finance, the remoteness residential areas of the poor from the urban cities, and their uncollateralized risk. Poor s projects always of small scale in nature and they always lived in very remote and even some times primitive areas in Muslims countries. In additions to that Muslims countries only very recently recognized the essentiality of the microfinance as a tool of empowering low income group, reducing unemplyment and thus elevating the poverty. Adding to that the weakness of Islamic microfinance infrasturactures such as the spread of Islamic financial institiutions and the relevant financial regulations and the unavailability of popular Islamic micro finance agencies or effective program in these countries. While the extreme povery is global phenomena not limited to the Muslim countries, the strcutured finance and right choices of fincnacing programs, policies to elaviate it, is very essential and urgent. This is because although the World Bank planned to end the extereme poverty by the end of 2030, some evidence showed that people in the poorest regions of rural Africa can be even lift themselves out of extreme poverty in five years time if proper means and tools of microfinance exist. This paper attempt to move beyound traditional microfinance to structure Islamic microfinace by sector and places and even by professions to faciltate the particular needs of poorest people based on thier diversity. Strucured Islamic microfinace by diversity might represent the right internvention for achieving better financial inclusion among the poorest in Muslim comunities. The Readiness of Islamic Microfinance: Islamic Microfinance is very effective and essential for creating hope not only for the poor on and above the poverty line as shown by the traditional microfinace, but also for the extreme poor among 2

the comunity. Muslims extremely poor remained exceculed through traditional microfinance for many reasons. They are volunterily exceclussion due to the practices of the interest rate by conventional lending institions which considered riba that forebiden in Islam or non-volantorary exceculded because of disability to repay back the loan plus the interest. Islamic microfinance can easily overcome these challenges because of its wide scope to cover various diversity of customer whether based on thier expertise or sectroral dimention. This is in addition to its supported tools such as zakat, waqf, sadaqah. Abdulrahman (2007), investigated Islamic microfiance as a missing component in Islamic banking. His investigation revealed that despite the main objectives of microfinance poverty alleviation and enabling the poor to empower in the line with the principles of Islamic values, has not yet reseanably addressed by Islamic banks. Saad, Norma (2011) investigated various income generating activities financed through microfiance institutions in Malaysia. The study used survey to indenfiy which activity is viable to the microfiance institution and generating high income. While the study idenfied some high income generating activites, it found that the microfiance receiver lack the proper skills. Salwana et al (2013) showed that traditional microfinance has failured to satisfy muslims comunity because of its shift from poverty to focus on profit oriented business. In addition to that conventional microfinace loan being granted based on interst rate (riba from Islamic point of view) is not tailored to the Muslims beleive. Clemens and Gabriel (2013) invistegated the new transparency in Development Economics: Lessons from the Millennium Villages Controversy. They found that there is weakness in the claim of the World Bank that to end the extreme poverty by 2030. Further more, they added that the claim of the success of ending poverty might depend on the right programs and policies. The above studies showed some shorting comings on conventional microfinance while rase hope of whether Islamic microfiance can take a lead at least among Muslim communities. This lead us to investigate and test the readyness of Islamic microfinace in Muslims countires. The current situation showed that most Muslim countries political and economical unrest, particular the Arab countires, such as Egypt, Tunisa, Morocco, libya, Sudan, Jordan, Syeria, Iraq, Lebanon and Yemen. These political instabilty leads to unfavarable microfinance environment particularly among foreign investor. In addition to that most Muslim countries or communities area are affected by the draw back of the civil war or natural disasstors which sometime become strong barriers to reach the disadvantages people let a lone to eradicate their extreme poverty. Given the high unemolument amang the youth and adults in Muslims countries, the huge demand to access finance far beyond the available supply that given by the existence microfinance providers. 3

In addition to that being most of the microfinance providers are non-profit organizations which characteristics with limited capacity and weak management. These negative characterisitcs either limited thier abality to reach the poor that scatered in the vast rural areas or to have enough coverage for them to achieve better financial and social inclusion. Despite of the high liquidity of the Islamic banking banking system, is not translated into microfiance services to shrink the wide gap between the demand and the shortage of supply in many Muslims countries. These might be due to the political instabilty and the lack of confidence and coordination between microfinance institutions and the Islamic banking sector due to political and economic stability. Other might be related to the inexistence of the legal and regulation framework that might organized the relationship between the partners in Islamic microfinance. This represent one of the essential challenges related to the weakness of Islamic financial infrustructures facing Islamic microcredit in Muslims countries. Many Muslims countries not yet effictively activated the Islamic social fiancail inclusion tools such as zakat, sadqah, gard al-hassan and waqf in thier economical system which is very essential for acheving financail inclusion. In addition to that the limitation on Islamic banking system in term of spread over the country to reached the poors. They are either yet to be introduced in some countires such as Morocco or have limited involvement in microlending such as in egypt, Tunisa, Jordan, Lebanon, Syeria, and other African and Central Asia countries. Most of the Microfinance institutions in Muslims countries depend on conventional financial providers. They are either interest based commercial banks or non-governmental microcredit institutions with strong Western flavor. Given the specificity of Muslim nation these conventional institutions have limited impact on social and financial inclusion on Muslims low-income communities and hence eradicating the poverty in Muslims territories. Unlike Islamic finance, conventional microfinance addressed financial inclusion in isolation from the social inclusion while Islamic finance addressing the two mater simultaneously. Despite the recent phenomena of the growing microfinance institutions, most Muslim countries have very low financial inclusion. This is because previous evidences showed that two third of the populations in Arab world and Sub-Saharan Africa are financially unreached. While just over 10% of adults in most Arab countries have loan accounts with banks, micro-entrepreneurs have more difficulties to have access finance. Moreover, most of the microfinance providers if not all located in the urban cities; while the low-income groups in Muslims world are residences in the rural areas. 4

Islamic Microfinance Providers : Despite of the huge demand for Islamic microfinance among Muslims communities, due to the high unemployment and the poverty, Islamic microfinance do not keep peace with upraising demand. While millions of poor covered by the conventional microfinance only view thousands have reached by Islamic microfinance in Bangladesh. The situation is not much different in GCC countries and even worth in North Africa Arab countries. The recent report showed that the current Sharia compliant microfinance providers cover only one million out of 650 million Muslims living on less than $2 a day1. Given the considerable growth, Islamic banks might be the potential microfinance providers in Muslims countries. One of the main reason is the lack of clear policies and regulations for Islamic microfinance providers to carry on their duties in this essential developmental sector. One of the essential financial lending institutions are the bank. Banks are varies in Muslim countries either in term of the development and the outreach. Few countries have well-developed Islamic banking system such as Sudan, Iran, Pakistan, Malaysia, GCC but the majority particular in the North Africa, Sub-Saharah and Central Asia are still need more efforts even to introduce Islamic financial system or to attract more Islamic financial institutions from the neighborhoods to invest in them. Islamic banks represent a potential incubator for Islamic microfinance. The spread of Islamic financial institutions might be a good sign of for growing of Islamic microfinance in Muslim countries. The following diagrams show the total asset, total deposit and total financing that granted by Islamic banks in the three region of Islamic Development Bank (IDBG) member countries, namely Asia, Middle East and Africa for the last twelve years. 1 http://www.cgap.org/news/islamic-microfinance-challenge-2013 5

Asia Islamic Finance Providers: Total Asset, Total Deposit And Total Finance For The Period From 2004-2012 Year 2012 Year 2011 Year 2010 Year 2009 Year 2008 Year 2007 Year 2006 Year 2005 Year 2004 Total Asset Total Deposit Total Financing Average 324,863,750 230,478,691 196,662,656 Maximum 673,515,908 518,084,759 444,046,746 Minimum 143,540,763 444,046,746 83,013,886 Data Source - IBISonline.net the amount thousands USD The above diagrams represent Islamic banks in Asia. It shows Islamic banks in this region are growing on average 22.4% in term of asset that reached total of USD673,515,908 at the end of the year 2012 from USD 143,540,763 in the year 2004 2. The total deposits and total finance has also grown on average to 518,084,759 and 444,046,746 from 444,046,746 and 83,013,886 consecutively for the same period. 2 Islamic Research and Training Institute, IBIS Databased. 6

Middle East Islamic Finance Providers: Total Asset, Total Deposit and Total Finance for the Period from 2004-2012 Year 2012 Year 2011 Year 2010 Year 2009 Year 2008 Year 2007 Year 2006 Year 2005 Year 2004 Total Asset Total Deposit Total Financing Average 207,443,172 133,162,546 114,012,232 Maximum 316,521,518 215,024,148 190,176,553 Minimum 62,520,446 46,456,957 42,454,453 Data Source - IBISonline.net the amount thousands USD The above diagrams represent Islamic banks in Middle East region. It shows Islamic banks in this region are growing on average 22.4% in term of asset that reached total of 316,521,518 at the end of the year 2012 from USD 62,520,446 in the year 2004 3. The total deposits and total finance has also grown on average to 215,024,148 and 190,176,553 from 46,456,957 and 42454453 consecutively for the same period. 3 Islamic Research and Training Institute, IBIS Database. 7

Africa Islamic Finance Providers: Total Asset, Total Deposit and Total Finance for the Period from 2004-2012 Year 2012 Year 2011 Year 2010 Year 2009 Year 2008 Year 2007 Year 2006 Year 2005 Year 2004 Total Asset Total Deposit Total Financing Average 14,979,435 11,855,479 7,395,951 Maximum 20,148,622 16,122,574 9,419,695 Minimum 6,341,030 5,112,997 3,844,451 Data Source - IBISonline.net the amount thousands USD The above diagrams represent Islamic banks in Africa. It shows Islamic banks in this region are growing on average 22.4% in term of asset that reached total of 20,148,622 at the end of the year 2012 from USD 6,341,030 in the year 2004 4. The total deposits and total finance has also grown on average to 16,122,574 and9, 419,695 from 5,112,997 and 3,844,451 consecutively for the same period. Generally Islamic banks in three region were growing on average 22.4% in term of asset that reached total of USD4,973, 864,698 000 at the end of the year 2012 from USD 212610742000 in the year 2004 5. The total deposits and total finance has also grown on average by 21.5% and 20.6% consecutively for the same period. Despite of the remarkable growth of Islamic banking sector in 4 Islamic Research and Training Institute, IBIS Database. 5 Islamic Research and Training Institute, IBIS Data- based. 8

general, Muslim countries still dominated by the conventional counterpart. For instance while there are 54 banks in Lebanon only four are Islamic banks. The number of Islamic even less in the Muslim majority countries such as Egypt, Tunisia, and Morocco. Banks being conventional or Islamic are licensed under the supervision of the central banks to provide arrange of financial services including microfinance. In addition to that Islamic banks subject to the Sharia h advisory board at the level of the banks or at the central bank levels such as in Sudan. Only few countries such as Sudan, Yemen, and Malaysia have issued circular to stimulate Islamic banks to involve in microfinance services. The Central Bank of Sudan permitting Islamic banks to use up to 12% of their reserve in granting micro financing. Moreover, beside the establishment of Islamic microfinance units, the Sudanese Central Bank grant license to one specialized bank, which is the Sudanese Family Bank to extend microfinance, based on Sharia h. Second important microfinance providers are the non-banks institutions. Most of the non-banking microfinance providers in Muslim countries are local or international Non-governmental Organizations (NGOs) provide conventional microcredit services based on interest rate apart from their other services related to their mandates. The majority of the non-banks microfinance providers adopt individual lending methodology while only a few specialized in-group lending such as women and agricultures in rural areas. One of the most important limitations of the NGOs are multidisciplinary mission intuitions under the management of the ministry of interior. Beside others, they also involve in the activities of financial and social inclusion development programs. Most of these NGOs are international and grant their lending based on Riba. Hence, they involve in achieving multipliable goals, which weakened their performance in achieving considerable financial inclusion among Muslims communities. Other challenges face these unprofitable organizations might be the limited capacities building and the weakness in management. In addition to that, most of them have multidisciplinary missions and concentrate on microcredit. Given the huge supply and demand mismatching, NGOS far below the ceiling of meeting the demand microfinance brewers. Other non-banks microfinance providers come in form of Funds or developmental program provided by multilateral banks such as IDB or government ministries. Islamic microfinance now cover millions of extreme poor and disadvantages people in many Muslims countries but still far less than the required level due to many constrains and challenges that will be discussed in the following section. 9

Islamic Microfinance: Moving Beyond Financial Inclusion The recent evidence showed that conventional microfinance that focused on profit making has faced many challenges in Muslims countries. Profit maximization through microfinance, leads to excessive microfinance lending and eventually might creates market saturation. In Bangladesh the microfinance was growing very fast since 1990 but then sharply change the direction as the market saturated because of the excessive lending. Conventional microfinance lends only the active poor and low-income group and leaves extreme and destitute poor behind. Hence in based on conventional microfinance lending behavior extreme poor always financially excluded because of their high risk. Since conventional microfinance seeking profit and the extreme poor people might consume the loans since they are lacking the basic needs. Thus by focusing in profit making out of financing the low income group and depriving the extreme poor from the small loans financing, conventional microfinance is financial and socially excluded the destitute people from microcredit and hence other activities such as saving and skills improvement related to microfinance at whole. Conventional microfinance pre-conditions for granting microcredit is the poor must be economically active and having entrepreneur skills. These conditions might not exist for the majority of the deprive people around the world in general and Muslim communities in particular. Therefore, most conventional microfinance the customers lay around the poverty line. Islam not differentiate between poor people based on drown line of poverty. Islam divides poor people based on two main categories of Fuqara and Masakeen. Fuqara are the people that have no enough substances to satisfy their basic need for one day while Masakeen the people that have no enough substances to satisfy their basic needs for the whole year. In this case Islamic microfinance providers might not prevent Fuqeer who is highly skills in certain specialization, trustful from lending him through profit sharing if the outcome of project viable. Fuqeer is also illegible in Islam for both Zakah, Sadaqah the most effective Islamic tools for social inclusion. So Islamic gives the satisfaction of the basic needs for Fuqara and Masakeen high priority through recommended tools to be implemented by the state, institutions and even wealthy people from their wealth when ever fulfill certain requirement such as al-nisab in term of the Zakah and voluntary charity (Sadaqah). Hence Islamic microfinance is moving beyond conventional counterpart to provide effective social and financial inclusion simultaneously through its twin tools that credit lending and Zakah that to be given directly to the extremely poor in cash or in kind to satisfy their argent and basic needs. Islamic microfinance expected to be more ethical that focus more in the social responsibility rather than only profit maximization. Islamic microfinance is very ethical when it grants finance and more ethically at 10

time of repaying the loan. Islam encourages not being hardship with people you lend and have natural default for which unable to pay back the loan even if before there are not Fuqara. And if someone is in hardship, then [let there be] postponement until [a time of] ease. But if you give [from your right as] charity, then it is better for you, if you only knew. Evidence showed that the failure of the dominant conventional microfinance to satisfy extreme poors in Muslim countries. In addition to the religious conservativeness the extreme poor require first to satisfy their argent need before moving along to production borrowing. These tools of satisfying the basic needs of the poor free of charge exist only on Islamic socioeconomic, through Zakah, Sadaqah and waqf. Zakah is the right of poor in the wealth of rich Muslims being companies, banks or individuals. Other factor that may cause the failure of the conventional microcredit is interest rate based (Riba) financing which forbidden in Islam. Despite of their extreme poverty, Muslims poor are very reluctant to take usury. In addition to that interest based need collateral or grantor to secure the payment of the loan which is difficult for the poor not having even their daily basic need. Islamic microfinance also, more appropriate than the conventional for the entrepreneurship, SMEs and extremely poor even interm of the modalities. Being based on sale or profit and risk sharing contracts, Murabahah, quart al- Hassan, Ijarah, salaam, Istisna a and muzara a, etc Islamic microfinance best modalities to address the diversities needs and business nature of the poor or SMEs being Muslims or even non-muslims. Poor required diverse range of microfinance services that to cover their wide scope of need as far as possible. Islamic microfinance is more accurate way of micro financing to the poor since it provides various microfinance products. In addition to that Islam would not prefer the idea of granting unproductive microcredit loan for purpose of gathering more profit from Fuqara and Masakeen. Islam encourages providing the tool of production to the poor which might increase their income and help them to make more saving. Unlike the previous conventional microfinance provide by the NGOs, the current 11

practices of Islamic microfinance might exceeded the microcredit to the micro-saving, micro-insurance and other nom-financial micro-services such as capacity building. Conventional microcredit is one way to be granted based on the interest taking gain and without sharing the pain with the borrower as the matter in the Islamic microfinance. Moreover, Islamic microfinance is more inclusive than the conventional microcredit that addresses the social and financial inclusion simultaneously. Islamic microcredit not targeting only low income group of people and more appropriate for the unemployed and skills group such as the graduates students and educated people, farmers, and alike. Hence Islamic microcredit targets different clients with a wide scope of lending products. Given the high unemployment among Muslims youth, Islamic microfinance could be the best modalities to mitigate the risk of disadvantages graduates and other group of youth than the conventional counterpart. Islamic microcredit can be structured based on the specialization and the professionalism of the poor and the unemployed people by categories. In Sudan microfinance used to finance veterinary projects for the graduated universities students such as producing eggs and chicken through partnership between family bank, Omdurman Islamic University and the students. Islamic instruments such as Salam, Muzarah and even Istisna a can be used to finance working capital for disadvantages rural people in Muslims countries regard less having income or not since they have expertise in certain business. These instruments also can best fit for financing pre-shipping and postshipping for entrepreneurship and SMEs imports and exports. Other modalities such as profit and loss sharing (Musharakah and Mudarabah) can also fit for many disadvantages financial needs and small scale industries. Through Zakah, Sadaqah, Waqf and Qard al-hassan these unemployed disadvantages people can be socially included by providing with the necessary needs before leaping to the next step of the microcredit. Islamic social intervention tools will pave the roads to the effective microfinance. Thus by empowering extreme poor and disadvantages people Islamic microfinance moving beyond financial inclusion to social inclusion and preserve human dignity. Conclusions: The current situation of high unemployment and the widen whole of the disadvantages people in Muslims country have spotlight the need of proper access to the micro-financing. Currently poor and low-income people in Muslim countries has little access to either conventional or Islamic microfinance. This study investigates why microfinance facing more challenges to improve the life of 12

the poor people in Muslims countries. Despite of the existence of the Islamic banking, the evidence showed that conventional microfinance is dominated the microcredit activities in Muslim countries. Hence more people has deprived from access microfinance either because of the adopted interest rate by conventional microfinance providers which is forbidden in Islam for those who are more conservative or they are extremely poor that cannot fulfill the criteria of the conventional microfinance. Countrary to the conventional microfiance, Islamic microfiance may used Zakah, Sadaqah, Waqf and Qard al-hassan to make socially inclusion to the disadvantages people by providing them with by the necessary needs before leaping to the next step of the microcredit. Islamic social intervention tools will pave the roads to the effective microfinance. Thus by empowering extreme poor and disadvantages people Islamic microfinance moving beyond financial inclusion to social inclusion and preserve human dignity. 13

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